By David Rogers
Leading fund managers see less upside potential for the sharemarket in 2022 as pandemic-era stimulus is dialled back in response to inflation and lessening Covid-19 restrictions.
Still, they retain some optimism based on the outlook for the economy and interest rates.
In 2021, the local market scored one of its best annual returns since the global financial crisis of 2007-09 as corporate earnings recovered from a collapse at the start of the pandemic. Australia’s benchmark S&P/ASX 200 index rose 13 per cent in the year to December 31.
It was the best rise since an 18 per cent jump in 2019 and the fifth biggest since a 31 per cent rebound after the GFC. On a total return basis, the ASX 200 rose 17 per cent for the year.
It came as investors largely brushed off a resurgence of Covid-19 associated with the Omicron strain, as the economic impact was expected to be temporary.
The local market was little affected by the start of monetary policy normalisation and surging cost inflation amid expectations of a durable recovery as Covid restrictions eased.
But the ASX 200 has stalled in recent months as corporate earnings growth peaked, plunging iron ore prices hit miners, central banks started to lessen their asset buying and lift rates in some cases and China’s growth outlook was downgraded after the near-collapse of its biggest property developer.
The ASX 200 was left behind by the tech-heavy US market in 2021. It also lagged the European markets with their skew to large quality and defensive companies.
However, it did much better than China, which was hit by a regulatory crackdown, and also outperformed the Japanese market, which faced a rise in the yen against the US dollar. The S&P 500 index was up 27 and Europe’s STOXX 600 index was up 22 per cent as of Thursday.
China’s Shanghai Composite and Japan’s Nikkei 225 rose less than 5 per cent for the year.
After collapsing at the start of the pandemic, the 12-month forward price to earnings valuation of the ASX 200 hit a record high near 21 times in late 2020 as investors anticipated a jump in earnings after unprecedented policy stimulus and the advent of Covid-19 vaccines in late 2020.
The market valuation fell to about 17 times by July 2021 as growth in earnings estimates outpaced a rebound in the index. It finished the year at a historically elevated 18.3 times, with an expected 12-month dividend yield at a relatively low 3.7 per cent as the Reserve Bank’s cash rate target remained at a record low of 10 basis points, promoting a “search for yield”.
Looking ahead to 2022, expectations of economic reopening as the impact of the pandemic moderates, combined with a high consumer savings ratio, rising employment growth, healthy corporate balance sheets and low rates should give a constructive backdrop for Australian equities.
“The prospect for a high single total return from equities over 2022 remains our central case,” Wilsons Advisory equity strategist David Cassidy said. “It is hard to get too bearish around the domestic economic backdrop for 2022 as the economy continues to chase down a more normal setting.
“Strong vaccine coverage should underwrite the domestic recovery in 2022.”
While valuations rose over 2021, Australian corporate earnings had scope to return to their long-term trend, giving “medium-term upside risk for corporate earnings”.
“For equities, the prospects of a mid-cycle slowdown and debate around how long good times can last are expected to dominate investor debate in 2022,” he said. “This is particularly the case offshore, where the brakes on monetary policy are likely to be gently applied over 2022.”
But a “hawkish pivot” by the Fed amid persistently high inflation and slowing growth was a risk.
“Under that scenario, we cannot rule out equities falling 5-15 per cent in quick order, similar to the experience in 2013 and 2018,” Mr Cassidy said.
“Australian equities would not be immune in this scenario.”
Companies were “acutely aware of cost pressures” across global supply chains, raw materials and labour, and Covid-19 lockdowns associated with new variants or waning vaccine efficacy might curb earnings estimates, he said. A close result in the federal election might lead to a minority government.
Geoff Wilson, chairman of $5.5bn fund Wilson Asset Management, which has 120,000 shareholders across the eight listed investment companies that it manages, said equities were still likely to be the best asset class in 2022, but with much more muted returns than 2021.
He expects recent volatility to continue as central banks start winding back easy monetary policy settings, new Covid-19 variants emerge and economies deal with inconsistent lockdown measures.
Whereas in 2021 equities experienced “the most favourable policy conditions possible” since the pandemic, 2022 would be “a year for monetary authorities to walk the tightrope of unwinding easy monetary policies”. Financial conditions might tighten, restraining the growth outlook.
“Volatility suppression is over, so expect a lot of swings in the market,” Mr Wilson said.
He favours sectors exposed to the short end of the yield curve, such as insurers.
He also likes consumer staples and healthcare as defensive plays, as well as high-quality, high-cashflow companies, but is avoiding sectors and companies that were “one-off Covid winners”.
Still, record economic stimulus, and reduced consumer expenditure have greatly improved household balance sheets and should support “revenge spending” on goods and services as conditions normalise. In retail, WAM funds are exposed to companies that were impacted through the pandemic, like physical store networks and those that sell goods leveraged to the reopening.
Mr Wilson also expects producers of commodities like iron ore to do well as “China will probably be the only country with a big economic expansionary push”.
But he doesn’t like the information-technology sector in the short term due to the risk of high valuations in those sectors being impacted by rising interest rates around the globe.
Overall, he notes that the pandemic appears to be morphing into an endemic disease, which increases the likelihood of governments pursuing a “herd immunity or flu-like treatment policy”.
“It feels like each variant that emerges is getting less deadly and more contagious,” he said.
Tom Millner, director and portfolio manager of Contact Asset Management, said 2022 would be much like 2021 in terms of Covid-19 impacts on supply chains and the workforce. In these circumstances he was focusing on companies with pricing power.
“The main themes are going to be very similar,” he said. “What we are seeing now on that (Covid-19) front, is not just issues on product delays and supply-chain issues, but there’s a huge issue in servicing and labour shortages.
“There are some labour shortages already and if half your workforce gets Covid and is forced to isolate for two weeks, it’s going to make a pretty ordinary situation (on labour supply) a lot worse.”
While expecting the world will adapt to Covid over time, Mr Millner is wary of companies that could be impacted by staff shortages and those that don’t have pricing power.
“Woolworths is a good example recently – revenue is growing OK but the cost of doing business in this environment is being a real drag on some of these companies’ earnings,” he said.
Mr Millner likes companies like Sonic Health for its exposure to Covid-19 and general pathology, Amcor, which has been able to push through significant price increases, and ARB and Reece, both of which have also been able to maintain high profit margins.
As for the housing market outlook, he’s wary of the potential for banks to keep increasing their home loan rates even if the Reserve Bank doesn’t lift the official cash rate next year.
Among the banks, Contact Asset Management owns shares in Commonwealth Bank and National Australia Bank, based on its view that they are the best retail and business banks respectively.
Commodities are likely to do well again next year, with Australian dollar still “quite reasonable” in the low 70 US cents area, and a “pretty significant disjoint in supply and demand which is underpinning prices and should be able to be maintained over the next 12 months.”
Canaccord Genuity equity strategist Tony Brennan said Australian shares could outperform if Australian long-term government bond yields were restrained by RBA policy remaining on hold.
“Global markets approach 2022 with uncertainty, including the course of the pandemic and potential new variants, and the path of inflation and central bank policy tightening,” he said. “How quickly interest rates might rise remains unclear, but with scope for inflation pressures to ease as activity returns more to normal over time, it may be that central banks still do not need to tighten overly aggressively to maintain sustainable recoveries, in our view.”
With Australia’s economic recovery delayed by recent lockdowns but under way again, inflation pressures less pronounced than overseas, RBA tightening not imminent and valuations “more reasonable”, he sees scope for the S&P/ASX 200 to push further into the high 7000s.
But investors needed to be open to the risks. Inflation could clearly prove more persistent globally, interest rates could shoot up and economic growth may be disappointing.
If Australia’s unemployment fell more rapidly to 4 per cent or less in the next six to nine months and wage growth picked up, the RBA would have to tighten soon after, possibly within 12 to 18 months. Still, that would probably be later than some other central banks, such as the Fed, and so could see Australia’s bond yield spreads to the US narrow, restraining the Australian dollar.
Overall the S&P/ASX 200 had “scope for some catching up” after lagging behind the S&P 500.
A market PE ratio of 17 to 18 times should be sustainable if bond yields didn’t shoot up and expectations of a 15 per cent rise in earnings over the 2022 and 2023 financial years were “reasonable”.
“But when economic growth is strong and business conditions buoyant, forecasts tend to prove conservative,” Mr Brennan said. “We believe they have the potential to get revised up over the next 12 months, possibly in the order of 10 per cent, which would support the ASX200 pushing into the high 7000s next year and potentially generating another solid return.”
Macquarie Australian equity strategist Matthew Brooks doesn’t expect the same level of economic volatility seen at the start of the pandemic, as the world has adapted to life in a pandemic.
But tapering of bond-buying by central banks combined with diminishing fiscal stimulus and generally high asset prices meant there was still a risk of equity market volatility.
“We believe the cycle was already slowing into a ‘mid-cycle slowdown’ and that given the low equity risk premium there was already a risk of volatility,” he said.
“There is a risk of more lockdowns as cases rise, plus a new variant adds an additional risk. On the positive side, rising Covid-19 concerns also delay monetary tightening.”
Perpetual Investments Head of Investment Strategy, Multi Asset, Matt Sherwood, said the anticipated lessening of central bank support in 2022 “comes at a challenging time” as the global economy is “slowing anyway” and a sizeable reduction in fiscal support and labour-market slack is likely to see 2022 end with ‘‘trend-like’’ growth in most major advanced economies.
Another growth challenge is China, which is seemingly going through a regime change, with President Xi Jinping more interested in the distribution of growth than its size. A tightening monetary policy had seen China’s credit impulse signal a “large and prolonged growth moderation”.
“Overall, 2022 is looking to be a challenging year for investors as central bank tapering, rising inflation and any subsequent policy hike are likely to spark higher bond yields, which should weigh on equity valuations,” Mr Sherwood said.
“Meanwhile rising rates, fiscal policy withdrawal, slowing growth and rising costs are set to weigh on earnings growth … 2022 is set to be a transitional year where the world tries to get off its stimulus addiction, and investors question the floor that central banks have put under rich asset valuations.”
Overall, Perpetual’s Mr Sherwood cautions that much has changed in the past two years and the investment environment ahead is “very different to what we’ve seen since the early 1980s”.
“Investors are facing a terrain characterised by low prospective rates of return and higher volatility, and with bond yields so low, they will not only have to identify undervalued assets, but also finding new portfolio diversifiers,” he said.
“While the biggest asset for asset accumulators is still time, the dilemma for retirees is quite profound as central bank policy has seen yields on all income-producing assets fall to record lows.”
The challenge now is how to sufficiently diversify against equity market risk.
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